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A tenant’s refusal to pay rent and the borrower’s resulting failure to make debt service payments did not trigger a “bad boy” loan guaranty because the lease was never terminated by operation of law, a California Court of Appeal has held.

In GECCMC 2005-C1 Plummer Street Office Limited Partnership v. NRFC NNN Holdings, LLC (referred to in this Post as the “Plummer decision”), the court’s holding resulted in a heavy loss of more than $40 million for the lender. The court’s holding demonstrates the necessity of carefully evaluating lending risks and coordinating remedies in lease and loan documents, particularly when a real estate asset has a single tenant.

Facts of the Case

In the Plummer decision, the lender loaned $44 million to a borrower. With the money, the borrower purchased two commercial projects in Chatsworth, California. The borrower leased the properties to Washington Mutual Savings and Loan as the sole tenant. The loan was non-recourse, secured by the properties but not any other assets of the Borrower, subject to exceptions for borrower misconduct. An affiliate of the borrower, Northstar, executed a loan guaranty that contained triggers that corresponded to the borrower misconduct non-recourse carve outs.

Northstar’s guaranty to the lender provided that “[t]he Loan shall be fully recourse to Guarantor, and Guarantor hereby unconditionally and irrevocably guarantees payment of the entire Loan, if any of the following occurs after the date hereof: . . . (iv) without the prior written consent of the [Lender, either lease] is terminated or canceled.”

Washington Mutual went out of business and it and its successors stopped paying rent and abandoned the properties. The borrower ceased making loan payments to the lender. The lender took title to the properties through a non-judicial foreclosure sale in which it bid approximately $11 million. The lender then brought suit against Northstar, the guarantor, for the balance due on the loan — approximately $42 million plus attorney fees and costs.

Court’s Decision

The principal legal issue was whether the tenant’s ceasing to pay rent and abandoning the property terminated the leases, triggering the guarantor’s duty to pay the amount owning on the loan if the leases were “terminated” “without the prior consent of Lender.” The trial court concluded that the leases were terminated without the lender’s consent and the guarantor was liable.

The Court of Appeal disagreed, holding that the guarantor was not liable under the guaranty. When the tenant stopped paying rent and abandoned the premises, the leases were not terminated as a matter of law. Both leases contained provisions, pursuant to California Civil Code section 1951.4, that the leases continued in effect for so long as the landlord did not terminate the tenant’s right of possession, notwithstanding the tenant’s breach of the lease. The leases expressly provided: “No act by Lessor other than giving notice of termination to Lessee shall terminate Lessee’s right of possession.” The borrower never gave notice of termination of the leases. (Why would the borrower do so under these facts?)

As a result of the lease provisions and operation of California Civil Code section 1951.4, the leases did not terminate and the guaranty was not triggered. The court reasoned that its interpretation of the guaranty was consistent with the parties’ intent, expressed in the deed of trust and other loan documents, to carve out exceptions to the loan’s non-recourse provision only in the event that borrower committed certain “bad boy acts” that pose particular risks to the lender’s interests and collateral. Those same acts could trigger the liability of the guarantor. But in this case, because none of the express “bad boy” acts occurred, so the lender’s sole recourse was to the collateral.

The lender tried to argue that although the lease termination provision in the guaranty resembled a “bad boy” guaranty it should operate like an absolute guaranty because full recourse is triggered regardless of whether the lease is terminated by the tenant or the landlord (i.e., the borrower). However, the court did not accept that argument, stating that the leases were never terminated and only the borrower held the right to terminate the leases, which the borrower did not do. For the same reasons, the tenant’s repudiation of the leases did not trigger the guaranty. The leases expressly provided they could not be terminated by an act of the tenant.

Analysis

Do you think the lender believed, at the time the loan was made, that the guarantor had no obligation if the borrower stopped making debt payments on the grounds that its sole tenant decided to walk from the lease? The answer to this question is almost certainly no, but the court’s decision doesn’t provide any facts to help us understand the thinking of the loan officer or loan committee. Did the lender underwrite this loan believing that Washington Mutual was essentially at no risk of default?

Going forward, lenders and their counsel will want to pay close attention to remedies in leases and loan documents. Lenders may be tempted to require their borrowers to include lease continuation provisions in order to continue collecting rents from a defaulting, creditworthy tenant. However, as this case instructs, if a tenant suffers a financial calamity and goes out of business, those lease continuation provisions have little utility and can actually be harmful if a “bad boy” guaranty is not properly structured.

The language of a loan guaranty should also be carefully reviewed so that it reflects the expectations of the parties. Does the lender expect that the single tenant will provide the sole source of funding for the loan? Or does the borrower need to back up the loan and have incentive to find a replacement tenant? If the latter is so, the guaranty could have provided that any abandonment of the premises by its single tenant combined with a failure of the borrower to make debt service payments triggered the guaranty. The trigger would not be “termination” of the lease, but abandonment of the premises regardless of whether the lease was “terminated.” If the original tenant goes out of business and abandons the property, the borrower should find a replacement tenant and continue to make debt service payments during the search. Then, the incentives are properly aligned between the borrower and the lender: both want a stable rental stream. Of course, there are circumstances where a lender may be willing to take on the additional risk after extensive underwriting of the single tenant, but the pricing model for the loan would likely have to be adjusted to account for the additional risk. The Plummer case offers a unique view into decisions that were made during the real estate finance bubble prior to 2008 and their heavy financial consequences.

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